Performance Evaluation, Managerial Hedging, and Contract Termination

We develop a dynamicmodel where a principal contractswith an agent to operate a firm. The agent, protected by limited liability, trades privately a market portfolio to hedgemarket risk in his compensation. When liquidation cost of the firm is proportional to its size, the principal manages the termination risk by loading the contract with a positive market component, which alleviates termination risk in normal market conditions but makes termination more likely after negative market shocks. The optimal contract displays a dynamic mixture of absolute and relative performance evaluations and is implemented using a dynamic deferred compensation account.